On November 13, 2008, a group of investors led by Versata Enterprises (Versata group) announced that they had taken a 5.2% interest in Selectica, an enterprise contract management business. The acquisition of this toe-hold heralded what appeared to be the first step in an ordinary course hostile bid. But what happened next was unprecedented, involving the deliberate triggering by the Versata group of Selectica’s poison pill (www.practicallaw.com/5-383-2209). The trigger would lead to pending litigation between Selectica and the Versata group in Delaware Chancery Court. The upcoming trial has the potential for the first Delaware court decision on the propriety of a board allowing a pill trigger as well as the appropriate threshold for a poison pill.
Selectica is a creature of the internet boom. Back in March 2000, Selectica had its initial public offering (IPO), raising $120 million. It was a true offering of the times. Within a month Selectica’s stock traded as high as $154.44 a share, but nine months later Selectica’s stock traded down over 90% at $17.19 a share. Since that time, the company has struggled to find a profitable business. Selectica has become a zombie tech company. It has never made a profit and instead lost over a $140 million since 2000, surviving on cash from its IPO and subsequent capital raisings. As of the new year 2008, Selectica’s stock closed at $0.84 a share and its market capitalization was about $19.8 million, below its cash on hand of about $24 million.
Trilogy, Inc., a member of the Versata group, had previously offered to acquire Selectica in 2005 for $4 a share. So, the group’s subsequent announcement on November 13, 2008 that it had accumulated a 5.2% interest and was contemplating a full offer was not a surprise. What happened next was. Selectica responded on November 19, 2008 by amending its poison pill to lower the applicable triggering threshold from 15% to 4.99%. Selectica justified this maneuver to protect its approximately $140 million in net operating losses (www.practicallaw.com/8-382-3642) (NOLs) and carryforwards.
Under Section 382 of the Internal Revenue Code, a company which experiences a significant ownership change in a three-year period is limited from using NOLs arising before that ownership change. Generally, a 50% increase in ownership by stockholders owning 5% of the company in any such three-year period comprises a sufficient ownership change. If such a change occurs, the company is limited from using these pre-change NOLs and any other built-in losses to credit future income. Because of the danger of such a change in ownership, a number of companies have recently adopted low threshold poison pills to protect their NOLs and carryforwards. Examples include Hovnanian Enterprises, Inc., Stamps.com, Inc. and USG Corporation.
Selectica lowered its poison pill threshold to 4.99%, but excepted out the Versata group so long as they did not acquire any further interest in Selectica. What happened next is inexplicable and appears to be a game of chicken gone wrong. Instead of suing in Delaware Chancery Court, the Versata group deliberately triggered the pill on December 18 and 19, 2008 by purchasing an additional 154,061 shares, purposely becoming an acquiring person under Selectica’s poison pill.
Selectica’s poison pill was an ordinary flip-in/flip-over pill. A flip-in pill gives stockholders the right to acquire additional shares of their company (the target). A flip-over pill gives stockholders the right to acquire shares of the acquiror. Consequently, as a result of the Versata group becoming an acquiring person, the poison pill rights detach from Selectica’s common stock and trade separately. The rights then become exercisable in accordance with the terms of the poison pill, ten business days after December 19, 2008. However, under the terms of its poison pill, Selectica’s board could prevent this by exercising its right under the pill to create an exemption for the acquisition. But instead of creating an exemption or otherwise amending the plan to delay its trigger, the special committee of the Selectica board of directors chose a different path. On January 2, 2009 the committee allowed the flip-in provision of the pill to trigger and ordered the exchange of each outstanding right, in effect as of the close of business on January 2, 2009, for one share of Selectica’s common stock. The Versata group was excluded from this exercise.
The result was the first pill trigger in modern times. In fact, there are only two other recorded pill triggers in memory, both from the early days of the pill when they were much less effective. One of these was by Sir James Goldsmith the alleged role-model for the character Sir Larry Wildman in the movie Wall Street. In 1985, Sir Goldsmith deliberately triggered a flip-over poison pill in his 1985 bid for Crown Zellerbach. That pill, since it contained only a flip-over provision, was only exercisable on the acquisition of the entire company and then only for stock of the acquiror. Goldsmith avoided the triggering of Crown-Zellerbach’s pill by foregoing a second step squeeze-out acquisition. Here, the Selectica pill contained both a flip-in and flip-over provision, standard for the pills of today. The result of this triggering was that the Versata group ownership interest was diluted from 6.7% to 3.3%.
The implementation of the special committee’s order was not easy. Selectica’s stock stopped trading on January 6, 2009 for the distribution of these new shares to be arranged. It would not be until a month later on February 4, 2009 that the stock would again begin trading and the shares exchanged for the rights. It is unclear why this took so long, but perhaps the Selectica board had second thoughts or settlement negotiations between the parties were occurring.
To prevent further acquisitions by the Versata group, the special committee of Selectica reset the pill restoring the same 4.99% trigger. The company also sued the Versata group on December 22, 2008 in Delaware Chancery Court for a judicial ruling that its actions were appropriate.
On January 16, 2009 Versata filed its answer. The Versata group argued that the actions of Selectica’s board violated its fiduciary duties. Versata’s arguments centered on the fact that Selectica was unlikely to ever use these NOLs since Selectica had never made a profit and was unlikely to do so in the foreseeable future. Rather, the board was using the NOL pill to entrench management. Here, the Versata group cited Selectica’s own statements in its most recent Form 10-K that “[g]iven our history of operating losses and our inability to achieve profitable operations, it is difficult to accurately forecast how results will be affected by the realization of net operating loss carryforwards”.
In particular, a pill is subject to review under the Unocal standard under Delaware law. It cannot be preclusive or coercive and must be reasonable in relation to the threat posed (see Practice Note, Fiduciary Duties of the Board of Directors: Defensive Measures (www.practicallaw.com/6-382-1267)). In addition, the restrictions at issue here are seemingly justified by Section 202 of the Delaware General Corporation Law, which allows stock transfer restrictions. In this context, a NOL poison pill would seemingly be appropriate as reasonable to protect the company’s profits.
However in light of Versata’s answer, the issue in the Selectica case appears more likely to focus on the reasonableness of Selectica’s claim that it was justified implementing this low threshold poison pill given its lack of profits. In addition, the deliberate trigger of the pill by the Versata group may also affect any ruling if the court finds that the Versata group has unclean hands here and whether the board, once the threshold was reduced, had no choice but to act. Therefore, while we may get some good dictum, we are unlikely to get any definitive ruling on the validity of NOL poison pills per se. More likely the court will rule on how viable Selectica’s NOLs are.
The Selectica case comes in light of a significant rise in poison pill adoptions. According to Factset MergerStat, in 2008, 122 companies adopted their first poison pills to fend off takeovers. Only 71 companies adopted poison pills for the first time in all of 2007. While companies can under Delaware law have a shadow pill ready to be adopted even after a hostile offer is announced, this adoption trend likely recognizes the difficulties a small company may have in adopting a poison pill in time before a bidder can accumulate a sizable position. The increased adoption rate of poison pills and the rise of the NOL pill, may mean that the ultimate question of the appropriate threshold for these pills may still be answered before the Delaware courts even if the Selectica case does not address the issue.
The Selectica case is now scheduled for trial in March, 2009.